Global

Markets will remain stuck in a trading range, driven by two policy feedback loops: the Fed's and China's.

For the month of May, the model underperformed both global equities and the S&P 500. For the month of June, the model is further paring back its risk exposure.

This month's <i>Special Report</i> reviews the literature on equity market timing, and identifies the key indicators that historically have had the best track record. We then aggregate the indicators into an overall scorecard that should prove to be valuable for investors in these volatile times.

Risks to global growth remain to the downside. Selling pressure in cyclical markets and assets will escalate. EM currencies will make new lows versus the U.S. dollar, the euro and yen. Take profits on our long JPY/short KRW and long JPY/short SGD trades. Short KRW versus an equal-weighted basket of the U.S. dollar, yen and euro. Continue underweighting Peruvian equities.

The pace of U.S. oil supply destruction accelerated at the end of April, as yoy losses increased to 470 thousand barrels per day (Mb/d) for the week ended April 29.

The end of the Debt Supercycle will be a key theme influencing economic and financial trends for many years to come. Its hallmark will remain the inability of central banks to engineer a new credit cycle, despite extremely low interest rates. China is one of the few remaining countries where the Debt Supercycle has yet to end, and history suggests the catalyst for a turning point will be a financial crisis.

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.

Historically, carry trades have generated very large profits with limited volatility. Since 2008, this has not be the case. Going forward, carry trades should continue to underwhelm.

Profit contractions normally occur during recessions, but there have been three exceptions since 1980: 1987, 1999 and a very brief period in 2012 (shaded portions in the chart). All three cases involved a mid-cycle slowdown in nominal GDP growth, while labor compensation growth trended sideways (second panel). The deceleration in sales activity was evidently perceived to be temporary, such that business leaders did not respond by limiting wage gains, trimming payrolls or slashing capital spending. The absence of Fed tightening at the time likely calmed fears of an extended slowdown. Indeed, the Fed cut rates in 1987 and 1998, and implemented QE3 in 2012. The result was that the slowdown in top line growth and the margin squeeze proved shallow and short-lived. We believe a similar phase is underway today. Several of the factors driving the profit recession appear to be at or close to their nadir. Commodity prices, and oil prices most importantly, have stabilized. Many key indicators of Chinese growth are rebounding, suggesting that monetary and fiscal stimulus is beginning to pay off. The global LEI has not yet turned up, but its slow erosion is in sharp contrast to the plunge that typically occurs before recessions. Purchasing managers' surveys have ticked higher in the U.S., Japan, Canada, the U.K. and China, signaling that the global manufacturing recession is ending. Bank profits could be near the worst as well, depending on the evolution of NIRP policies and net interest margins. Moreover, the manufacturing recession has not spread to the service sector in the major economies, where job creation has held up. While persistently low productivity growth and a secular bottom in the labor share of income in the U.S. will remain a headwind for global earnings, they should be dominated by even a modest cyclical revival in global growth due to high corporate operating leverage. The implication is that we do not foresee a prolonged earnings contraction. (Part II) Global Earnings Recession: How Deep? How Long? (Part II) Global Earnings Recession: How Deep? How Long? Looking again at the chart, global EPS surged following the modest profit recessions in 1987 and 1999. Output growth accelerated sharply, while commodity prices entered a robust bull phase. The global output gap shifted into "excess demand" territory, providing the business sector with some pricing power. Nominal GDP growth re-accelerated in absolute terms and relative to labor costs, contributing to a substantial rise in profit margins. The aftermath of the 2012 profit dip was an altogether different affair. Margins only edged higher due to the tepid rebound in nominal GDP growth. Commodity prices were roughly flat. Meanwhile, the still-large global "excess supply" gap robbed the business sector of pricing power. The result was that EPS growth barely climbed out of negative territory in 2013 and 2014. Today, the global output gap is closer to zero than was the case in 2012/2013, especially in the U.S. However, pricing power is still left wanting at the global level, based on the continued decline in global manufactured goods prices and depressed core consumer price inflation in most of the advanced economies. Oil prices have more upside potential given that the supply-side is responding to low prices, as discussed in the Overview. Nonetheless, our commodity experts do not foresee sustained price increases outside of oil anytime soon. Finally, the global leading economic indicator, a reasonably good bellwether for global EPS growth, has yet to turn higher (bottom panel). Bottom Line: While the profit recession will not be extended or deep, investors should not expect the kind of surge in EPS growth that followed the 1987 or 1997 earnings contractions. Please see yesterday's Special Report for additional details.

The factors that drove the recent rally - Fed dovishness, China reflation, and a pickup in economic data - are largely over.